POST-WAR ECONOMICS 201
employment when unemployment
is at this natural rate. If
governments spend money
to reduce unemployment below
the natural rate, pushing up
inflation, wage earners will further
inflate their wage demands.
Two things can then happen.
Unemployment can return to the
natural rate, at the new, higher
inflation rate. Or the government
tries to maintain the lower
unemployment level, but at the cost
of a spiral of accelerating inflation.
The conclusion was clear: it is
futile for governments to try to
stabilize employment through fiscal
policy. Increasing the money supply
likewise only leads to higher prices.
In the long run the Phillips Curve
is a straight vertical line at the
natural rate of unemployment.
The time lag between monetary
changes and output changes is
often only a few quarters. Price
movements can take between
one to two years or more to
come through. These lags are
considerably variable. For this
reason Friedman advised
governments against trying to
use monetary policy to actively
manipulate markets because it is
easy to misread what is happening
in the economy. They should follow
a simple rule: ensure that money,
however it is defined, increases by
a constant amount—2–5 percent
(depending on the definition of
money chosen) annually.
The new classical
macroeconomics school, led by
US economists Robert Lucas and
Thomas Sargent, put forward a
revised version of this argument
based on rational expectations of
future economic policy. Friedman’s
model treated expectations as if
they only adapted to past mistakes.
Lucas and Sargent argued that
people’s expectations are forward-
focused. People can see what
governments might plan, so any
government attempt to reduce
unemployment below the natural
rate will lead immediately to higher
inflation. In other words the
Phillips Curve is vertical in the
short run as well—governments
don’t ever have the power to
reduce unemployment.Monetarism in practice
It did not take long for Friedman’s
warnings to be proven correct. In
the 1970s the supposed Phillips
Curve trade-off fell apart when both
inflation and unemployment
increased together—a phenomenon
known as stagflation. Governments
started to introduce targets for
growth in the money supply into
their planning. Germany, Japan,
the US, the UK, and Switzerland
adopted monetary targeting in the
1970s. However, it proved hard to
control monetary growth. One
problem was which form of money
to target. Most central banks
targeted a broad version of money,
which included bank time deposits
(deposits that cannot be withdrawn
for a fixed period of time). However,
this proved hard to control.Attention then focused on the
narrow monetary base, namely
notes, coins, and reserves held at
the central bank. This was easier
to control but did not seem to enjoy
a stable relationship with so-called
broad money.
Monetarist experiments were
largely unsuccessful, but the
impact of monetarism was
significant. It grew from a policy
prescription about the money
supply to a program aimed at
reducing government involvement
in all aspects of the economy. Few
today would disagree that “money
matters.” Monetary policy receives
as much attention as fiscal policy
and is usually aimed at controlling
inflation. But the purest form
of monetarism and its policy
implications rely on controversial
assumptions: that there is a
predictable demand for money and
that the money supply can easily be
controlled by the authorities. In the
1990s countries moved away from
monetary targeting. Many began
to use the exchange rate to control
inflation or to tie interest rate policy
directly to inflation trends. ■US president Ronald Reagan and
UK prime minister Margaret Thatcher
were close conservative allies. Both
pursued strict monetarist policies in
their early years in office.In 1973, Chile became the first
country to implement monetarist
policies. Under dictator Augusto
Pinochet, a radical program of cuts
and privatizations was carried out.